The Accounting Fraud @ Worldcom: The Causes, The Characteristics, The Consequences, And The Lessons Learned

Causes Internal Environment Strategy or lack thereof The executive and strategic decisions at WorldCom were characterized by rapid growth through acquisitions In re WorldCom, inc., 200

THE ACCOUNTING FRAUD @ WORLDCOM:

THE CAUSES, THE CHARACTERISTICS, THE CONSEQUENCES, AND THE

understanding what led to the fraud, how the fraud grew, and what its effects were, lessons can

be derived to gain a better understanding of the reasons behind a fraud and to prevent future frauds from occurring or growing as big as the WorldCom fraud did

Acknowledgements

Dr Roush, for her patience, for her advice, for her time, and for her knowledge

Dr Benford and Dr Gibbs, for their continued support and time as committee members Gene Morse, the internal auditor at WorldCom when all this happened, for his internal insight into the case

Thank you

Dedications

For my family, who fed me, clothed me, and distracted me, all to make sure I stay sane during this knowledge gaining experience

For the numerous cups of tea that made me fall asleep and saved me from information overload

For my grandfathers: the businessmen

Contents

Introduction 1

Causes 3

Internal Environment 3

Strategy (or lack thereof) 3

Company Culture 5

Corporate Governance 10

Auditing: to detect or to neglect 14

Audit Committee 14

Internal Audit 15

External Auditors 16

External Environment 18

Double Bubble 18

Greed at Wall Street 20

Causes Conclusion 23

Characteristics 25

Definition of Fraud 25

The Misstatement of Line Costs 26

Releasing Accruals 26

Capitalizing Line Costs 28

Revenue 29

Discovery 30

The Internal Auditors 30

Sullivan‟s White Paper 31

Fraud Triangle 32

Pressure 32

Opportunity 34

Rationalization 35

Characteristics Conclusion 36

Consequences 39

Effects on Internal Environment 39

Effects on External Environment 41

Regulations 43

Consequences Conclusion 45

Conclusion 47

Appendix: Figures 48

Figure 2: Fraud Triangle 50 Figure 3: Internal Control Structure 50 Works Cited 51

Introduction

WorldCom was a provider of long distance phone services to businesses and residents It started as a small company known as Long Distance Discount Services (“LDDS”) that grew to become the third largest telecommunications company in the United States due to the

management of Chief Executive Officer (“CEO”) Bernie Ebbers It consisted of an employee base of 85,000 workers at its peak with a presence in more than 65 countries LDDS started in

1983 In 1985, Ebbers was recruited as an early investor of the company and became its CEO It went public four years later Ebbers helped grow the small investment into a $30 billion revenue producing company characterized by sixty acquisitions of other telecomm businesses in less than

a decade In 1999, Ebbers was one of the richest Americans with a $1.4 billion net worth

From the outside, WorldCom appeared to be a strong leader of growth In reality, the appearance was nothing more than a perception On June 25, 2002, the company revealed that it had been involved in fraudulent reporting of its numbers by stating a $3 billion profit when in fact it was a half-a-billion dollar loss After an investigation was conducted, a total of $11 billion

in misstatements was revealed

To understand fraud, why it happened, and what it constitutes, it is important to

understand not only the details of the accounting methods, as is summarized in The Report of Investigation conducted on WorldCom, but also what was happening in the environment of the company while the fraud was occurring

Therefore, the objective of this paper is to analyze the events that occurred before (causes) and after (consequences) the fraud, the accounting tactics utilized to accomplish this fraud (characteristics), and the lessons learned from each of the problems

Causes

Internal Environment

Strategy (or lack thereof)

The executive and strategic decisions at WorldCom were characterized by rapid growth through acquisitions (In re WorldCom, inc., 2003) “Growth, growth, growth…” (G Morse personal communication, October 22, 2010) By 1998, WorldCom had been involved in mergers with sixty companies Together, these transactions were valued at more than $70 billion, the largest of which, MCI Communications Corporation (“MCI”), was completed on September 14,

1998, and was valued at $40 billion (In re WorldCom, 2003)

According to Smith & Walter (2006), WorldCom was motivated by the low interest rates and rising stock prices during the 1990s From the beginning it committed itself to the high-growth strategies that relied on aggressive corporate actions that often involved “creative” accounting practices

Dick Thornburgh‟s investigation of WorldCom (2003) revealed a lack of strategic

planning, often depicted by nonexistent “proper corporate governance protocols.” While

documents called “strategic plans” were found, they only consisted of an overview of the

company‟s financial outlook in the event that WorldCom stopped the aggressive acquisitions They did not contain any realistic strategic plans (Thornburgh, 2003) There was no strategic committee and the decision makers mainly consisted of Ebbers, Chief Financial Officer (“CFO”) Scott Sullivan (“Sullivan”), and Chief Operations Officer (“COO”) John Sidgmore (“Sidgmore”)

Once WorldCom acquired the new companies, it failed to properly integrate the systems and policies that not only led to very high levels of overhead in proportion to the revenues but also to an extremely weak internal control environment (Breeden, 2003) Due to the fast pace of the acquisitions as well as management‟s neglect, the accounting systems at WorldCom were unable to keep up with integration and efficiency The lack of internal controls allowed manual adjustments to be made in the system without the emergence of any red flags, thereby

minimizing any chance of detection (Breeden, 2003)

To further this acquisition problem, the MCI merger caused WorldCom to take on a huge debt load In addition, MCI had a residential customer base with slower growth rates while WorldCom had historically served business customers, a customer base consisting of high

margins and less turnover (Katz & Homer, 2008)

The beginning of WorldCom‟s fall came with its attempt to merge with the second largest telecommunication company at the time: Sprint (WorldCom being the third largest) The plan was terminated by the U.S Department of Justice due to the lack of anti-competitiveness it would create within the telecommunications industry With no other companies to merge with, WorldCom‟s growth through acquisitions strategy came to a screeching halt (Clikeman, 2009)

According to Porter (1985), a competitive strategy searches for a favorable competitive position in a company‟s industry, aiming to establish a position in which the company is

profitable and sustainable against its competitors The management at WorldCom was so

determined to grow that it not only failed to create a competitive strategy, but also did not see

that with growth comes “the need to maintain” to prosper In the end, that lack of strategy

prevented it from effectively planning and determining a position to acquire that prosperity

Company Culture

Top Management’s Managing Style

According to Albrecht & Albrecht (2004), to prevent fraud, the opportunity to commit fraud should be minimal or nonexistent Creating a work culture of “honesty, openness, and assistance” is key to fraud prevention (Albrecht & Albrecht, 2004, p 61) First, it is important to hire honest people and train them in fraud awareness, and to present a code of conduct or ethics that is not only stated on a piece of paper, but is truly respected and followed by other employees including top management Second, a positive work environment must be created Third,

employees must be provided with assistance programs (Albrecht & Albrecht, 2004)

The growth through acquisitions “strategy” at WorldCom was enforced and reinforced by top management The consistent pressures from top management created an aggressive and competitive culture (in re WorldCom, inc., 2003) that did not contain any communication of the need for honesty or truthfulness or ethics within the company (Breeden, 2003) In fact, one former executive reports that the pressure became “unbearable-greater than he had ever

experienced in his fourteen years with the Company” (Zekany, Braun, & Warder, 2004) One employee stated that WorldCom was never a happy place to work, even when the company was doing well, the employees were forced to work 10, 12, or even 15 hour days but it balanced out with the higher compensation However, when the stock dropped, the employees were still

required to work the long hours even when compensation was all but gone (L Jeter, personal communication, October 17, 2010)

There was a large focus on revenues, rather than on profit margins and the lack of

integration of accounting systems allowed WorldCom employees to move existing customer accounts from one accounting system to another This allowed the reporting of higher revenues for WorldCom through which employees pocketed extra commissions that amounted to almost

$1 million (in Re WorldCom, inc., 2003) According to the Beresford, Katzenbach, & Rogers (2003), efforts made to establish a corporate Code of Conduct received Ebbers‟s disapproval He often described the Code as a “colossal waste of time.” Implementing a code of ethics and

having employees read and sign it periodically can reinforce ethical conduct as well emphasize that it is important to the company (Albrecht & Albrecht, 2004) The lack of a code of ethics at WorldCom shows that no training on awareness of fraud or ethics was conducted Therefore, it is very possible that when the employees reported existing customers as new ones, they were not aware of the obdurate consequences that may occur

The employees at WorldCom did not have an outlet to express concerns about company policy and behavior either Special rewards were given to those employees who showed loyalty

to top management while those who did not feel comfortable in the work environment were faced with obstacles in their need to express their concerns (Panday & Verma, 2004) Due to the multiple acquisitions, WorldCom‟s business units were spread across the eastern United States (see Figure 1) Hence, if an employee working at headquarters in Clinton, Mississippi was facing

a problem, he/she would have to contact the Human Resources department in either New York,

N.Y or Boca Raton, Florida This autonomous structure complicated matters further and

discouraged most employees from saying anything at all (Beresford, Katzenbach, & Rogers, 2003) The lack of an outlet to express concerns was not only problematic for regular employees, but also for the upper level employees who were asked to participate in the fraud Betty Vinson and Troy Normand, managers in Clinton‟s Accounting Department, were told to make journal entries on the instructions of the Director of General Accounting Buddy Yates (Beresford, Katzenbach, & Rogers, 2003) They followed his orders However, they both wrote a letter of resignation after they felt uncomfortable with the falsified journal entries they made The two never submitted their resignation letter due to their dependence on their jobs to support their families (Cooper, 2008)

A low fraud environment could have been created if WorldCom‟s culture consisted of positive work environment elements such as employee assistance programs that make it easier for the employees to not only report fraud, but decrease their own likelihood of committing it Open door policies, positive personnel, and operating procedures could have been implemented

to diminish the barrier between employees and upper management (Albrecht & Albrecht, 2004) Unfortunately, in the case of WorldCom, the personnel themselves were involved in the fraud

Yet, if the personnel were the ones to implement the positive work environment, they might not

have been involved in the fraud in the first place

On top of the lack of an ethical code and an outlet for concerns was the concept of

employee compensation with stock options Employees at WorldCom received a lower salary than their counterparts at competitors such as AT&T and Sprint (J Chalmers personal

communication, October 21, 2010) According to Chalmers, a lawyer who dealt with many WorldCom employee cases after the fraud, the gap between the competitors‟ compensation and WorldCom employee compensation was filled through stock options which further enforced management‟s ideology of focus on revenues The higher the revenues, the better the company appeared to Wall Street which in turn led to a higher stock price and higher compensation for both employees and management However, when WorldCom fell, so did the stock price, leaving its employees with worthless stock options Gene Morse (personal communication, October 22, 2010), one of the internal auditors who helped discover the accounting fraud, had been given the senior level director‟s stock options package If the stock had returned to its high and WorldCom had not fallen, his options would have been worth over $900,000 Morse stated that he never sold the options because he too, like the majority of other employees and stakeholders, believed in Ebbers‟s optimism about WorldCom

Ebbers played a huge part in turning LDDS into a “global telecom giant,” WorldCom, with the goal of acquiring the position as the “number one stock on Wall Street” (Panday & Verma, 2004) Ebbers had started out by managing hotels in 1974 (Clikeman, 2009) He

continued his “hands on” managerial style throughout his involvement in WorldCom even when the company had revenues amounting to billions of dollars (in re) He was known for taking risks (Katz & Homer, 2008) no matter how aggressive, towards making WorldCom‟s stock a highly demandable one According to Panday & Verma (2004), Ebbers created an individualistic culture where loyalty to a person was more important than loyalty to the company This created an environment where the boss was not to be questioned Therefore Ebbers‟s plan was the

company‟s plan

Sullivan was Ebbers‟s right hand man He and Ebbers had the same managing style Sullivan was known as a “whiz kid” who enjoyed the reputation of “impeccable integrity.” He was a leader that, like Ebbers, was not to be questioned The loyalty that existed at WorldCom was very important to keep the fraudulent activities that occurred bottled up Most of the

information was not fully available to employees, furthering this secrecy Even some who had the need to know the information (Zekany, Braun, & Warder, 2004), such as the internal

auditors, were able to view only some of the journal entries in the income statement and the balance sheet but never the entire documents (G Morse Personal Communication, October 22, 2010)

The combined management allowed the creation of a culture that was more suitable for a sole proprietorship than for a billion dollar corporation The aggressive nature of the managing style such as the plethora of acquisitions as well as the failure to integrate them properly created

an environment where employees were pressured to report high growths quarter by the quarter There was no emphasis or encouragement of honesty and integrity with those demands

According to Romney & Steinbart (2008), a work environment that emphasizes “integrity and commitment to both ethical values and competence” depicts good business, yet it all has to start

at the top Management that required and rewarded integrity and honest behavior (Romney & Steinbart, 2008) may have prevented what occurred at WorldCom Furthermore, if management had envisioned a more stable and long term outlook for the company, the quick paced

acquisitions may not have occurred Unfortunately, they did The approval for these acquisitions was given by the Board of the Directors

Corporate Governance

Board of Directors

According to Romney & Steinbart (2008), a Board of Directors that is active and

involved within an organization is an important internal control for the organization The

directors at WorldCom were from different backgrounds While some had widespread

knowledge and experience of business and legal issues, others were appointed due to their

connections with Ebbers (Breeden, 2003) The mix of the Board and the close ties to Ebbers led

to the Board‟s lack of awareness on WorldCom‟s issues The Board was inactive and met only about four times a year, not enough for a company growing at the rate that it was In addition, the directors were only given a small cash fee as compensation, thus an appreciation of stock was the only form of compensation available The directors also depended on company growth and stock appreciation for compensation, as did the employees and management They had a large amount

of influence on the approval or disapproval of company decisions Their approvals of the

acquisitions allowed WorldCom‟s growth to an increase that led to a higher stock price and a large amount of compensation Directors dependent on this type of “large issuances of equity” not only conveyed an unhealthy practice, but also created a conflict of interest where their goal became more focused on the growth of the stock than on what was in the best interests of the company (Breeden, 2003) Another conflict of interest arose for those board members that had strong ties to Ebbers Their closeness to Ebbers hurt their duty to be independent from the

company and its management

Due to the Board‟s lack of active participation, there was a lack of awareness about WorldCom‟s matters According to Thornburgh (2003), management aided that lack of

awareness by presenting the directors with very limited information about the company and its acquisitions Thornburgh (2003) states multibillion dollar transactions were approved by Board

of Directors with the limited information At times they were approved with discussions that lasted less than half an hour Sometimes these discussions did not involve the Board at all and at other times no documents were even presented concerning the terms of the transactions In addition, no risk assessment was performed on these acquisitions (Breeden, 2003)

Romney & Steinbart (2008) recommend that the Board of Directors of a company should

be responsible for overseeing management and inspect its “plans, performance, and activities” (p 208).The directors should also approve the company‟s strategy, review its financial

statements, and evaluate security policy They should also always interact with the auditors, both external and internal

Loans to Ebbers

“We stand by our accounting.” Ebbers made this statement during an earnings conference call with analysts in February of 2002 (in Re WorldCom, inc., 2003) However, what was

unknown at the time was Ebbers‟s personal financial situation Ebbers had made several

purchases for which he had acquired loans and used his WorldCom stock as collateral The purchases were quite extravagant and included the largest ranch in Canada, a yacht construction firm and yard, a marina, motels, a hockey team, and even a yacht Ebbers named “Acquasition.” Once the price of WorldCom stock fell, Ebbers was required by the banks to fill in the margins

between the value of his loans and the fallen value of his stocks (Panday & Verma, 2003)

Instead of selling his stock, which he thought would further cause a decline in stock price on Wall Street, Ebbers requested the Board to approve personal loans to fill in the margins

(Breeden, 2003) To ease the process, Ebbers took advantage of the lack of independence of the board members who were loyal to him such as Stiles Kellett, chairman of the Compensation Committee, and Max Bobbitt, chairman of the audit committee Not only did the two allow the loans to grow to more than $400 million, but also when the Board found out about these loans, they failed to take any action and allowed the loans to carry on (Breeden, 2003) A strong Board, that included directors who were more focused on the shareholders rather than on what „Bernie‟ recommended, could have avoided the multimillion dollars in loans that further deteriorated WorldCom‟s financial situation This shows that it is important to inform the directors about company policies, mission, and ethics since they are not a part of the company‟s daily life and culture

The Compensation Committee

One main reason Ebbers‟s loans were approved was the Compensation Committee The Committee‟s authority was stated in a charter from 1993 that listed a vague description of its power to supervise the compensation of the officers (Beresford, Katzenbach, & Rogers, 2003) However, in the company‟s proxy statements, the committee had the power to determine the

“salaries, bonuses, and benefits” of the officers (p 270) The Committee approved the loans to Ebbers without confirming with the Board and asked for the Board‟s approval after the loans had already been paid out (Beresford, Katzenbach, & Rogers, 2003) The Committee was the only one at WorldCom that met regularly: seven to seventeen times per year during the fraud period

of 1999-2001 Similar to the Board of Directors, the Compensation Committee failed to properly conduct its role in placing appropriate pay programs that not only supported the company‟s mission and strategy but were also in the best interests of the company The approval of Ebbers‟s loans does not qualify as an action in the company‟s best interests, but only in the best interests

of Ebbers and the board members who were loyal to him

Lessons in Corporate Governance

Corporate governance involves the protection of shareholders by the Board of Directors (P Roush, personal communication, 2011) The approval of Ebbers‟s personal loans was not in

the best interests of the stakeholders Breeden (2003) mentions that there are no “checklists” of achieving “good” governance There is, however, a need of a Board that contains individuals who not only possess business knowledge and skills but also have “healthy sensitivity to norms

of proper behavior” (p 23) The focus then turns to the creation of value for the company rather than to simply avoid wrongdoing and to have a good code of ethics (Breeden, 2003)

Breeden further emphasizes “doing the right thing,” stating that every Board whether at a national, business, or university level will at some point be faced with tough decisions and challenges The key to the success of the Board is to take action and resolve any problems with competency (Breeden, 2003) Unfortunately, with WorldCom, when the Board was presented with the challenge of approving Ebbers‟s loans, among other large acquisition decisions, it failed

to take action and limit Ebbers‟s power on the Board Perhaps the Board did not realize the consequences that could occur as a result of those actions committed against their long time

friend nor did it have the competency to take control of the board and take a strong position against the decisions

Auditing: to detect or to neglect

Audit Committee

A director‟s independence from management is a key factor in a successful company At WorldCom, an Audit Committee was established to conduct relations with Arthur Andersen, the external auditor An Audit Committee consists of a selected number of Board members who are

to meet from time to time with the company‟s auditing firm and discuss the progress of the audit, the findings, and resolve any conflicts that may occur between management and the firm

(Louwers, Ramsay, Sinason, & Strawser, 2008) However, in WorldCom‟s case, the lack of independence and awareness of the Board as a whole trickled down to the audit committee The committee‟s chairman, Max Bobbitt, was very loyal to Ebbers Hence, the members of the committee, including Bobbitt, were either unaware or had known about the fraudulent

misstatements for the years 1999, 2000, and 2001 and choose to ignore it According to Breeden (2003), the Committee oversaw the $30 billion revenue company when it met for about three to six hours once a year

While the Committee was represented positively, the accounting controls within were

“virtually non-existent” (in Re WorldCom, inc., 2003) It appears the lack of activity was more

of a “going through the motions” as opposed to the Committee sitting down and understanding the policies, the internal controls, and the audit programs that were a necessity to the company‟s core structure (Breeden, 2003) Even though Arthur Andersen acknowledged WorldCom as a

“maximum risk” client and mentioned to the Committee that WorldCom had “misapplied GAAP (Generally Accepted Accounting Principles) with respect to certain investments,” the committee chose to ignore it and in the end Arthur Andersen gave WorldCom a clean, unqualified opinion (Zekany, Braun, & Warder, 2004)

The audit committee‟s negligence depicts another weakness in WorldCom‟s internal controls Therefore, it is very important to have members in the committee that fulfill their duties

by overseeing the corporation‟s internal control structure as well as making sure that the

company complies with “laws, regulations, and standards” (Romney & Steinbart, 2008) The members should also periodically meet with the firm‟s internal and external auditors to ensure the audit process is efficient and be aware of the company‟s operations The fulfillment of these duties is now a requirement due to Section 301 of the Sarbanes-Oxley Act discussed later

Internal Audit

WorldCom‟s Audit Committee failed to meet with the Internal Auditors of the company, who had the duty to provide the Audit Committee with an independent and objective view on how to improve and add value to WorldCom‟s operations (Louwers, Ramsay, Sinason, &

Strawser, 2008) Not only were the personnel in the internal audit department not enough for a large company, but they also lacked the proper training and experience to conduct the testing of the company‟s controls

According to Thornburgh (2003), Ebbers or Sullivan would have the department work on

“special projects” that were very time consuming and would normally not be part of the audit

during the day and then stay late at night to complete the audits that were often delayed Cynthia Cooper, the Vice President of the Internal Audit function and the individual whose department discovered and reported the fraud, stood by the intense work in the hopes that top management

would see her department as important and add the personnel and resources needed to efficiently

maintain the internal audit function (Thornburgh, 2003) Gene Morse (personal communication, October 22, 2010) adds that the internal auditors were provided with limited access to the income statements and balance sheets with only a partial picture of the company‟s financial situation that prohibited them from properly assessing the finances of the company

The Internal Audit department is intended to be independent and report directly to the Audit Committee to avoid the influence of top management (Louwers, Ramsay, Sinason, & Strawser, 2008) This form of relationship was lacking at WorldCom Furthermore, Ebbers wrongly associated the duties of an internal auditor with those of an external one In reality, an internal auditor does little work on the financial statements and focuses more on “improving the organization‟s operations” (Louwers, 2008, p 629), rather than conducting the actual operations The department must try to reduce or eliminate risks that could create losses and also improve the efficiency of operations Lastly, the department should help ensure compliance with

management, laws and regulations as this would add value to the company (Louwers, 2008)

operational and financial situation of WorldCom The Committee itself did not meet on a regular basis either and was unable to properly take actions to fix the situation Yet, the external auditor, Arthur Andersen, was the one responsible for providing an independent opinion of the financial situation at WorldCom for investors and creditors The auditing firm also failed to carry out its duties properly

According to Beresford, Katzenbach, & Rogers (2003), Arthur Andersen‟s failure to detect the fraud was due in part to negligence and in part to the tight control top management kept over information A flaw in Andersen‟s approach was that it limited its testing of account balances, relying on WorldCom‟s perceived strong internal control environment (Beresford, Katzenbach, & Rogers, 2003) Unfortunately, WorldCom‟s internal control environment was inefficient in many ways, and therefore allowed Andersen to overlook “serious deficiencies” that existed in the internal environment (p 223) If the external auditors had performed their work

properly, the fraud could have been discovered long before 2002 Moreover, even though the top

management‟s control over the information was suspicious, Andersen failed to bring this

problem to the attention of the Audit Committee (Beresford, Katzenbach, & Rogers, 2003)

Speaking at an event at Baylor University, David Myers, former comptroller at

WorldCom, stated that the WorldCom audit was Arthur Andersen‟s largest audit in the region,

and that Arthur Andersen wanted to keep WorldCom as a client (Acc guest 2009) Unfortunately,

the retaining of WorldCom as a client was due to the consulting revenue that it brought in to Arthur Andersen The auditors spent more time selling those consulting services and less time conducting analytical reviews and testing controls According to Roush (personal

communication, 2011), this situation created a conflict of interest because the auditors would first consult a company about how to increase performance or efficiency and then go back to the same company and independently audit it Top management at WorldCom was aware of this and made the journal entries in the way they would be tested by Arthur Andersen In addition, Myers notes that Arthur Andersen may not have overlooked the details purposely but rather the auditors were pressured to have the job completed as soon as they could It appears that the relationship with WorldCom was more valued than performing appropriate audit work Andersen‟s close relationship with Ebbers, in the end, resulted in a lack of professional skepticism: the questioning attitude an auditor must have when in the field

External Environment

The external environment during the fraud period also served as a basis for WorldCom‟s

growth during the Internet bubble When the bubble burst in early 2000, WorldCom‟s share price

plummeted along with most of the volatile Internet and telecommunications companies

Double Bubble

Dot-Com Bubble

In 1996, UUNet, the technology and Internet sector of WorldCom, announced that

Internet traffic was doubling every 100 days According to Odlyzko (2003), while the statement may have been true from 1996-1997, when Internet was indeed growing, the growth failed to be carried on towards the later years when it was most often cited This statement was not only made by Internet and telecommunications companies to boost investment in their companies, but also, by scientists trying to demonstrate the need for research within this new technology

(Odlyzko, 2003) Hence, people believing in the evolving myth started to invest rapidly into the volatile stocks of Internet and telecommunication companies A majority of these companies were not even making a profit Odlyzko emphasizes that people did not stop to think about how something could grow so fast and that the myth was repeated enough times that it became a reality He states that in order for the traffic to keep on increasing, within a year every person would have had to be using the Internet twenty four hours per day, a scenario that was not

plausible at the time In his most recent paper, Odlyzko (2010) mentions the cause of bubbles like the Internet and telecommunications one is gullibility This “beautiful illusion” of enormous profits and a better lifestyle block one‟s ability to think objectively In the end, the growth is empowered by this gullibility Essentially people end up “drinking their own Kool-Aid”

(Odlyzko, 2010) These actions later turn into anger and disbelief once the bubble is gone and reality becomes apparent

Telecomm in Trouble

During the false growth of the Internet, the Telecommunications Act of 1996 was passed The act allowed long distance companies such as WorldCom to compete in the local market and allowed the local phone companies to compete in the long distance market Therefore it opened the different parts of the telecommunications industry to fierce competition and lowered the price

of telecomm services (Economides, 1998)

As more and more Internet companies came into the market, an increased demand in broadband services appeared Consequently, WorldCom started leasing fiber optic cables to support the demand (Gene Morse, personal communication, February 8, 2011) According to

Morse, when the hype of the internet stocks diminished, the Internet companies went out of business and canceled their services with WorldCom Unfortunately for WorldCom, the leases it had made were two to five year agreements that could not be canceled To make matters worse, companies like Cisco introduced switches that at first doubled the capacity the cable could carry, then soon gained the ability to carry thirty two-times capacity

WorldCom had bought and invested a vast amount of capital into a transatlantic cable that when leased to other companies had only 4% utilization The switches allowed the

companies to lease only a small amount of the cables and acquire more capacity (Morse,

personal communication, February 8, 2011) Morse refers to the idea of a restaurant with a hundred tables, but that only four of the tables are used on any given day The problem here is that there was no return on the investment, yet WorldCom still had to incur the expenses for purchasing the cables The timing of the situation was characterized by optimism, expansion, and opportunity so it was hard for anyone to predict anything other than growth Jack Grubman, an analyst on Wall Street, stated “build it and they will come” when referring to the fiber optic cable expansion (The wall street fix, 2005)

Greed at Wall Street

The perceived unlimited growth the Internet and telecommunication bubbles were

creating led to a significant flow of capital to WorldCom and other telecommunications

companies (Thornburgh, 2002) The capital flow allowed the share prices of the telecomm

industry as a whole to increase vastly WorldCom‟s share price was in the $20 range in early

1995 and rose to more than $90 during 1999 WorldCom stock during the 90s was characterized

by six different stock splits On the other hand, when the new millennium started, WorldCom‟s

stock faced a continuous decline until it became worthless It was also delisted from the Nasdaq market once the misstatements were made public (Thornburgh, 2002)

The scenario was reminiscent of other telecommunications companies who also saw a large downfall in their stock prices What differentiated WorldCom stock was that WorldCom was deceiving the public through the misstated financial statements and through Jack Grubman‟s repetitive “buy” ratings of the stock (in re WorldCom, inc., 2003)

Jack Grubman was an analyst for Salomon Smith Barney (“SSB”), an investment firm that was often involved in underwriting WorldCom‟s acquisitions He was one of the most powerful men on Wall Street What he said about a stock significantly affected its status on Wall Street He was so close to Ebbers that when he was invited to his wedding, SSB‟s investment banking department covered all his expenses (in re WorldCom, inc., 2003) After the fraud was revealed, it was discovered that from June 1996 through August 2000, Ebbers received IPO allocations through Grubman that allowed him to make profits totaling $11.5 million (Exchange hearing 03-72, 2003) The question that arises is why was this loyalty so important to Grubman?

The economic environment at the time permitted investment banks to have their analysts rate companies that were a part of their own clientele base, due to the repeal of the Glass-Steagall Act during the 1990s (Katz & Homer, 2008) This created a conflict of interest similar to how the accounting firms were offering their clients both consulting and auditing services In essence, when Grubman gave WorldCom‟s stock a “buy” rating, the public trusted him and bought more stock, thereby increasing its price When the price went up, top management at WorldCom was

able to use the appreciation to engage in more acquisitions which required underwriters such as SSB Thereby, SSB was able to charge large fees for performing the underwriting services From

1996 until 2000, SSB acquired a total of almost $76 million in fees from WorldCom (Exchange hearing 03-72, 2003)

Perhaps unknowingly or even knowingly, Grubman fulfilled the desire of top

management at WorldCom, who found that the stock appreciation allowed WorldCom to keep the fraudulent activities a secret for that much longer Grubman was pressured by his own

management to maintain positive ratings for the clients of his company and prevent any form of action that would make those clients take their multi-million dollar fees elsewhere (Exchange hearing 03-75, 2003) When then New York State District Attorney General, Eliot Spitzer, launched an investigation into SSB, Grubman left SSB The agreement he signed with SSB included compensation of about $19.5 million, plus $13 million in deferred compensation from previous years, which unfortunately did not serve as a lesson to analysts Rather, it showed them that the worst that can happen to them as an analyst is that they retire earlier with a lower net worth than they would have otherwise There is a dire need for standards and punishments for wrongdoing in the financial markets Some efforts have been made to create a more stable economic environment such as the Dodd-Frank Wall Street Reform and Consumer Protection Act that was passed on July 21, 2010 (FDIC Law, 2010) The act included the Volcker Rule, proposed by former Federal Reserve Chairman, Paul Volcker, and restricts US banks from making certain investments if they are not on behalf of the banks‟ customers Yet, continuous efforts are needed to ensure future stability

Causes Conclusion

What lessons can we learn from the causes of the WorldCom fraud?

WorldCom‟s internal environment was a mess waiting to happen It appears that even without the fraud, the company would have collapsed anyways, yet perhaps sooner than it really did The fraud was similar to a piece of gum patching a hole in a dam The external environment was the storm that caused the gum to lose its stickiness Lastly, the lack of proper personnel to detect and fix the hole was the auditing failure

The internal problems at WorldCom were its lack of a competitive strategy, weak internal controls, an aggressive culture that demanded high returns, and the failure to look out for what was best for the stock holder as well as the stake holder of the company

While the growth of a company is necessary for its sustainability, it is also important for the company to focus on the long term rather than only on the next quarterly report By doing so, the company emphasizes that it creates value not only for Wall Street, but also for its customers that are the drivers of the company

Employees of a company are also drivers for its growth and success However, the

competitive culture at WorldCom was characterized by loyalty to management with no regards

to ethics, honesty, or integrity (“doing the right thing”)

The Board of Directors served as an internal control that was a failure on its own part The duty of the Board was to correct the weakness of the company that management was unable

to see due to its lack of the independence from the company However, the Board appeared to be